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Beware of Central Bankers in Helicopters


Juxtaposing Fed policy actions against the current economic landscape to see if it makes any sense.

Michael Lewis had an epic piece on Greece by a similar title last month, and if imitation is the sincerest form of flattery, then this piece should be somewhat flattering if he were to stumble upon it. But where my piece lacks "epicness" in its writing, I make up for it by embedding a video. If only Les Grossman and the gang from Tropic Thunder could capture something so bracing:

Apologies if you find it contrived, banal, or cliché, but the fact is this: When you talk about central bankers nowadays, and Fed Chairman Ben Bernanke in particular, in my mind it's really hard not to use footage from Apocalypse Now for its imagery. The chairman, armed with his research economists, New York Fed Open Market Operations staff, and bags of money, is riding in low over the horizon, blaring Wagner's "Ride of the Valkyries" and trying to shoot down savers and risk-averse investors. But I don't see anyone in the Fed's Blackhawks (the modern-day equivalent to the Vietnam-era Huey) having the combination of panache, bravado, or sheer insanity of Lt. Col. Bill Kilgore.

And just like Kilgore making the declaration "You can either surf, or you can fight!" there's a certain level of insanity behind Fed policy and what that policy is trying to drive. It's like Bernanke is yelling "You can spend, or you can chase risk!" but there's no je ne sais quoi to that, sorry. To clearly see what the Fed is doing, we need to juxtapose its policy actions against the current landscape to see if it makes any sense. Frankly, from my perch, it doesn't. I thought I needed to say that just in case folks thought my last piece was an endorsement of QE2. (See Why QE2 Won't Be Enough).

What do I mean? Let's start with Fed policy. Here's a chart that takes a look at the Adjusted Monetary Base and Securities Outstanding on the Fed's balance sheet. To say these are linked is a bit of an understatement:

The monetary base is defined as the following, courtesy of Richard G. Anderson and Robert H. Rasche's Measuring the Adjusted Monetary Base in An Era of Financial Change (emphasis mine):

The adjusted monetary base is an index that measures the effects on a central bank's balance sheet of its open market operations, discount window lending, unsterilized foreign exchange market intervention, and changes in statutory reserve requirements. Such an index is important because the long-run path of a monetary economy's price level is primarily determined by the path of the central bank's balance sheet, adjusted for the effects of changes in statutory reserve requirements.

So obviously, the monetary base can give us clues as to where prices are headed in the future. And indeed, as monetary base expanded, so did MZM:

Other than the dip where we knew the Fed was selling Treasuries to ensure there was enough Treasuries in the market when everything and everyone was in crisis mode, there's another takeaway from this chart: The only way the monetary base will continue to grow is from additional purchases of securities. Purchases to just maintain the size of the Fed's balance sheet won't be enough to expand the monetary base. And there's a limit to what the Fed can purchase, not just in terms of asset types but also the size of the markets for each asset. The capital markets aren't infinite in size. Also, as all the charts also show, the country's money supply and the monetary base have flatlined in growth, and it coincides with the flatlining in Fed securities purchases. So the Fed has become the buyer of last resort and could ultimately be the only buyer of any resort.

But what's the basis for this policy in the first place? Enter Brian Sack, senior vice president of the New York Fed, and his explanation (emphasis, mine):

In terms of the benefits, balance sheet expansion appears to push financial conditions in the right direction, in that it puts downward pressure on longer-term real interest rates and makes broader financial conditions more accommodative. One can reach that judgment based on the empirical evidence from the earlier round of asset purchases, as mentioned before. In addition, the market responses to more recent news about the balance sheet also lean in this direction. The market response to the reinvestment decision at the August FOMC meeting seemed largely in line with the estimated effects from the earlier round of asset purchases, once we account for the size of the surprise and the anticipatory pricing that occurred ahead of its announcement. And the increased expectations for balance sheet expansion in response to the September FOMC statement also generated a sizable market response.
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